Working Paper No. 594 Revisiting “New Cambridge”: the Three

Working Paper No. 594 Revisiting “New Cambridge”: The Three Financial Balances in a General Stock-flow Consistent Applied Modeling Strategy By Claudio H Dos Santos1 Antonio C. Macedo e Silva2.3 May 2010 1 Research Scholar of the Levy Economics Institute of Bard College, New York, and Research Economist at the Institute for Applied Economic Research (IPEA), Brazil E-mail: [email protected]. 2 Professor of Macroeconomics at the University of Campinas, Brazil E-mail: [email protected]. 3 The authors would like to thank Francis Cripps, Franklin Serrano, Gennaro Zezza, Marc Lavoie and Wynne Godley for their comments on a previous version. The Levy Economics Institute Working Paper Collection presents research in progress by Levy Institute scholars and conference participants. The purpose of the series is to disseminate ideas to and elicit comments from academics and professionals. Levy Economics Institute of Bard College, founded in 1986, is a nonprofit, nonpartisan, independently funded research organization devoted to public service. Through scholarship and economic research it generates viable, effective public policy responses to important economic problems that profoundly affect the quality of life in the United States and abroad. Levy Economics Institute P.O. Box 5000 Annandale-on-Hudson, NY 12504-5000 http://www.levyinstitute.org Copyright © Levy Economics Institute 2010 All rights reserved Abstract This paper argues that modified versions of the so-called “New Cambridge” approach to macroeconomic modeling are both quite useful for modeling real capitalist economies in historical time and perfectly compatible with the “vision” underlying modern Post- Keynesian stock-flow consistent macroeconomic models. As such, New Cambridge– type models appear to us as an important contribution to the tool kit available to applied macroeconomists in general. and to heterodox applied macroeconomists in particular. Keywords: Stock-flow Consistent Models; New Cambridge; Aggregate Financial Balances; Heterodox Applied Macroeconomics JEL Classifications: B50, C82, E12 1 Our main contention in this paper is that modified versions of the so-called “New Cambridge” approach to macroeconomic modeling – e.g. Cripps et al. (1976), Godley and Fetherston (1978), Godley and Cripps (1983), Godley (1999a), Izurieta (2005), and Zezza (2009), inter alia – are both quite useful for modeling real capitalist economies in historical time, and perfectly compatible with the “vision” underlying modern Post- Keynesian stock-flow consistent (SFC) models (as discussed, for example, in Godley, 1999b, Lavoie and Godley, 2001-2002; Dos Santos, 2005 and 2006; Godley and Lavoie, 2007a; and Macedo e Silva and Dos Santos, forthcoming). Both claims may appear trivial at first. For one thing, it is now beyond doubt that the work done by New Cambridge economists at the Levy Economics Institute clearly anticipated the problems now facing the U.S and world economies.4 Moreover, one does find mentions to the three balances model in the modern SFC literature (e.g. Godley and Lavoie, 2005-2006 and 2007b). However, these mentions are invariably made in the context of simplified stationary models without private investment, the inclusion of which can change things considerably (as acknowledged by Godley and Lavoie themselves).5 And there still appears to be considerable doubt – even among heterodox economists potentially friendly to the approach – about why exactly the New Cambridge three balances approach (which many consider too aggregated and/or simple and/or based on implausible behavioral assumptions) is useful for applied macroeconomic modeling. More to the point, we see the “New Cambridge” approach as an elegant and parsimonious applied macroeconomic modeling strategy which can and should be dissociated from its “trademark” behavioral assumption according to which the private sector as a whole behaves in such a way as to keep the ratio of private financial assets (net of financial liabilities) to private disposable income relatively constant over time – and, more generally, from any particular behavioral hypothesis adopted by its practitioners in any given historical context. The details of our argument – which does not necessarily represent the (complex, nuanced, and ever-changing) views of the original “New Cambridge” economists6 – are presented in the fourth section of this 4 See, for example, Godley (1999), Godley and Izurieta (2002), Shaikh, Papadimitriou, Dos Santos and Zezza (2002), Godley, Papadimitriou, Dos Santos, and Zezza (2005) and Godley, Papadimitriou, Hannsgen, and Zezza (2007). 5 See, for example, Godley and Lavoie (2005-2006, p.252, footnote 15). 6 All New Cambridge economists have deeply inspired us. Some of them we are proud to call friends. And none of them will probably agree with us on everything we have to say. But which group of gifted economists ever reaches a consensus about anything complex, after all? 2 paper. Before we can get to those, we need first to remind readers of the exact meaning of the “three financial balances” that appear so prominently in New Cambridge papers (in section 1), of the large macroeconomic literature dealing with these balances (in section 2), and of the general characteristics of (and the Schumpeterian “vision” underlying) the modern Post-Keynesian “stock-flow consistent” literature (in section 3). Brief concluding remarks are presented in section 5. 1 – A primer on (Private, Public, and External) Financial Balances We all know from basic national accounting that: Y ≡ Cp+ Ip + Cg + Ig + X –M (Identity 1). In words, “GDP” (Y) is identical to “total expenditure in final goods and services”, i.e. the sum of private consumption and investment (Cp + Ip), government consumption and investment (Cg + Ig), and exports of goods and services minus imports of goods and services. Implicit in the identity above is, of course, the assumption that the economic agents can be meaningfully aggregated in three “institutional sectors”, i.e. the private, government, and external sectors. Evidently, agents of each of these three sectors continuously make unilateral transfers and pay property incomes to agents of the other two sectors. Let us, then, define: T = taxes paid by private sector agents to the government minus the net unilateral financial transfers made by the government to private sector agents minus the net property income paid by the government to private sector agents; Trge = net unilateral transfers made by the government to the external sector plus net property income paid by the government to the external sector; Trpe = net unilateral transfers made by the private sector to the external sector plus net property income paid by the private sector to the external sector. We can, therefore, rewrite the basic national accounting identity above as: Y – T – Trpe ≡ Cp + Ip+ Cg + Ig + Trge – T + X – M – Trpe – Trge. This, in turn, implies that: Y – T – Trpe – Cp – Ip ≡ (Cg + Ig + Trge – T) + (X – M – Trpe – Trge) (Identity 2). Or equivalently: PFB (Private Financial Balance) ≡ – GFB (Government Financial Balance) + CAB (Current Account Balance), 3 where PFB ≡ Y– T– Trpe–Cp–Ip; GFB ≡ T–Cg–Ig–Trge; and CAB ≡ X – M – Trpe – Trge. Obviously, private (government) financial balance equals private (government) saving minus private (government) investment. Identity 2 can then be trivially rearranged to show that: SAVp – Ip ≡ - (SAVg - Ig) + CAB (Identity 3), where SAVp (private saving) ≡ Y-T-Trpe-Cp; and SAVg (government saving) ≡ T - Cg - Trge, which expresses the well known national accounting fact that, ex-post, it is always true that total saving equals total investment in any given economy. Though the algebra of identity 2 – much less common than the third one – is trivial to anyone familiar with basic national accounting, the exact meaning of its first term, the private financial balance (which is a proxy for the “net lending by the private sector” to use modern national accounts terminology),7 is often non-trivial to many economists.8 We need, therefore, to clarify this specific concept before we proceed. In order to understand the various possible meanings of the private financial balance it is crucial to think of the private sector in disaggregated terms. Following both modern Post-Keynesian SFC models and national accounts, we find it useful to disaggregate the private sector in three smaller institutional sectors, i.e. the “households,” “firms,” and “banking” (or “financial”) sectors. In other words, it is often useful to think of total PFB as the sum of households’ FB, firms’ FB, and bank’s (or financial sector’s) FB. Consider a situation in which the private financial balance (net lending) is, say, $500. What does this imply for the financial balance of, say, the households’ (or firms’ or banks’) sector? The answer, in principle, is nothing at all. All it implies is that the sum of the financial balances of households, firms, and banks (all taken as “a whole”) is $500. And, of course, there are countless combinations of households’, firms’ and banks’ financial balances that add up to $500. This will be the case, for example, if the 7 See, for example, Lequiller and Blade (2006, chapter 8). The same concept used to be called “net accumulation of financial assets” (or “NAFA”) in the 1970s. We stick here to modern terminology, among other reasons because the term “net accumulation of financial assets” is now used in the national accounts to designate a completely different concept (see section 2). 8 A fact that, according

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